Streetwise Professor

November saw a mini-drama involving the CME, CFTC, and DTCC about the issue of SDRs.  (Acronym overload!)  SDRs being Swap Data Repositories, a spawn of Frankendodd-arguably the only good thing in the Title VII litter.

CME had filed to become an SDR, and wanted to require anyone who cleared swaps through CME to report the trade to its SDR.  The CFTC didn’t like the idea of tying clearing and reporting, and held things up: it had stated that the choice of SDR should be up to the customer.  So CME sued.  DTCC-which has its own SDR and would benefit if some CME swap deals were reported to it-filed as an intervenor in the suit.

Lo and behold, the CFTC approved the CME application, including the provision that tied clearing and reporting.  CME dropped its suit, and DTCC is stomping its little feet:

“The Commission’s action late yesterday was an unexplained and an abrupt reversal of course,” the DTCC, which runs a rival swaps data repository, said in a statement.

“This action is inconsistent with the Commission’s previous actions, and will cause market participants to question the finality of any Commission rule or interpretation.”

Two comments.

First, issues of tying and vertical integration are cropping up all over in trading and exchanges.  I just presented a paper at a conference honoring Oliver Williamson that looks at vertical integration between execution and clearing and settlement.  But the issues are also present in things like data centers and reporting and likely will be present in any service exchanges offer.  Regulators are hostile to these sorts of arrangements.  The lesson of my paper is that there can be-and in my view, typically are-good, transactions cost economics-based reasons for these sorts of vertical arrangements.  Regulators should take a deep dive into TCE and learn something about the potential benefits of vertical restrictions or vertical integration rather than continuing to indulge in their reflexive hostility to it.  What’s the transaction at issue?  What are the potential contractual hazards?  Are the contracting and governance methods chosen to implement the transaction well-adapted to the contracting hazards?

IOW, as if (40 plus years after Coase made an observation on the subject) it is rather astounding that regulators look at every vertical restriction with a jaundiced eye.

Second, in some respects this is like Groundhog Day for me.  I’ve seen this before.  I came across a similar controversy in my failed attempt to create a predecessor to SDRs-an “energy data hub”-back in 2003.  It was obvious then, and is obvious now, that there are substantial scale and scope economies in creating and operating an SDR, and that an SDR is a natural, multi-product monopoly.  It is highly likely that the efficient form of organization would be an industry utility/cooperative, likely a non-profit.

But as I experienced in ’03, industry players see this as a great commercial opportunity, and there is intense competition to establish for-profit data hubs and regulators will not mandate the creation of a single hub or pick a winner.  Hence, it is likely that in the end, in each jurisdiction there will be one dominant hub that could be quite lucrative.  Hence the intense competition to be the winner in a winner-take-all contest.  This competition is typically dissipative.  Moreover, if multiple SDRs do survive (because, for instance, the firms play some sort of oligopoly pricing game), there will be excessive costs due to incomplete exploitation of scale and scope economies (i.e., fragmentation is costly).

Which all means that although mandatory reporting to a data hub/SDR is a good idea, as a result of political economy considerations it will be implemented in a highly inefficient way.

Go figure.

Jon Corzine caused the demise of MF Global.

Poor management decisions by MF Global former CEO Jon Corzine triggered the brokerage firm’s collapse, while lax protections for customer funds contributed to the loss of an estimated $1.6 billion of customer money, congressional investigators have determined.

Evidence unearthed by the House Financial Services Subcommittee on Oversight puts the blame squarely on Corzine, the panel’s chairman, Rep. Randy Neugebauer, said in a preview of the report that will be released on Thursday.

“The responsibility for failing to maintain the systems and controls necessary to protect customer funds rests with Corzine,” the report says. “This failure represents a dereliction of his duty as MF Global’s chairman and CEO.”

Who knew?

Except anyone paying the slightest attention, I mean.  It has been beyond blindingly obvious since even before the implosion of the brokerage that Corzine was gambling for resurrection, and made the decisions that destroyed MF Global.  It was also clear that the firm was a managerial mess, a disaster waiting to happen.

But his “spokesman” says the failure was a collective one for which Corzine is not personally culpable:

A spokesman for Mr. Corzine said that “all of the firm’s significant business decisions…were subject to review, debate and approval” by MF Global’s board. “At all times, Mr. Corzine acted in good faith and did what he believed was necessary to turn around MF Global.”

Because boards are never, ever, ever the creatures of domineering, out of control CEOs.

The spokesman, Steven Goldberg, said that the panel didn’t find any evidence of “intentional wrongdoing” and that Mr. Corzine was working to turn around an already-failing business.

I see.  Taking huge risks-and running roughshod over risk controls to do so-is a turn-around strategy that only unintentionally results in mayhem.  His intentions were good, so everything’s just fine.  Big harm, no foul-because he didn’t mean it.

The fact that MF Global was “already failing” is precisely the motive for Corzine’s rashness.

The Neugebauer panel punts on the most important open question: who was directly responsible for the loss of customer money?  We all know that Corzine was the first mover who set of the chain of events that ultimately led to the looting of MFG’s not-so-segregated customer funds.  We knew that on Halloween, 2011.  But why, pray tell, we don’t know exactly who authorized this looting more than a year and two weeks after the firm’s collapse?

As I’ve written before, Edith O’Brien is essential to answering that question, but Edith O’Brien is silent because prosecutors refuse to grant immunity.

In the scheme of things, she doesn’t matter.  It is highly unlikely that she would have taken it upon herself to throw good customer money after bad Corzine bets.  And even if she did, letting her escape legal punishment would have no effect on the odds of a future recurrence of such a debacle.  It is more likely that someone else higher up in the firm made the call.  Given Corzine’s dominance, he is the most likely candidate for making that call.  Letting him skate would set a bad precedent that would encourage other CEOs to engage in such misconduct.  The balance of costs and benefits is clearly on the side of getting Ms. O’Brien’s testimony.

And indeed, this is Federal Financial Crime Prosecution 101: go for the big fish by catching and releasing the little ones.  The failure to follow this tried-and-true strategy is quite revealing, given the identity of the biggest fish: a made man in the Democratic Party, a former Senator and governor, and fund raiser for Obama.

Because of this pointed refusal to do something that would put Corzine at risk, the MF Global collapse remains the Immaculate Destruction, and the firm remains the Financial House Not Destroyed by Human Hands.  And the House Financial Services Subcommittee on Oversight does nothing to resolve that mystery.

Go to a conference where derivatives or Frankendodd are discussed, and you can’t escape without hearing somebody’s tongue trip over the word “extraterritoriality” (say it 5 times fast!) -the imposition of Frankendodd rules (such as swap dealer registration) on foreign firms.  Gensler has been quite aggressive in his interpretation of where the CFTC’s writ extends: in his mind, it basically extends everywhere that directly or indirectly could have an impact on US markets.  In an interconnected financial world, that doesn’t limit things much.

Foreign financial institutions (and other firms, such as pension funds and money managers) are less than thrilled.  To say the least.  Some smaller institutions have announced their intention to have no dealings with US firms that could put them in the monster’s grip.

Foreign regulators have also criticized US assertions of authority, both in writing and now in GiGi’s face:

Financial regulators from around the world have rounded on the main US swaps regulator over its attempts to extend new rules on derivatives overseas, warning of destabilising effects on the global financial system.

Supervisors from Japan, Europe and Hong Kong have previously criticised the Commodity Futures Trading Commission in written correspondence. On Wednesday, the regulators set out their concerns during a public meeting at the CFTC in Washington.

GiGi nodded, and then defended the CFTC’s actions.

Regulatory arbitrage is a concern, but unilateral assertions of US authority, and foreign pushback on those assertions, raise various concerns of their own.  In particular, they threaten to balkanize derivatives markets (and financial markets generally) as non-US firms limit their dealings with US entities.  This will reduce liquidity; tend to lead to concentrations of risk; and will impede the efficient allocation of risk.

Per usual, Gensler is appealing to a simplistic version of the financial crisis to justify his position, and not acknowledging the adverse consequences-most notably due to fragmentation-that will result from over-aggressive American initiatives.  Regulatory consistency across jurisdictions (which would mitigate regulatory arbitrage) ironically is undermined by the unilateral efforts of the US regulator to impose its will around the world.

This is particularly amazing given the CFTC’s less than glorious record at regulating a subset of US derivatives markets.  Hubris, anyone?  And unfounded hubris at that?

Speaking of regulatory hubris, David at Deus ex Macchiato is justifiably outraged at the assertion by an Irish regulator that global regulations of OTC markets had “the explicit policy objective” of reducing the size of these markets.  Because of course regulators know exactly how big OTC derivative markets should be and know with metaphysical certainty that the markets will reconfigure themselves to the regulatory fiat in ways that enhance stability.  Yes, these are the most complicated, interconnected markets in the world, so of course guys in Dublin and DC should know exactly how big they should be and exactly how they should be configured.  Because that always turns out just swell.

This is exactly what Hayek meant by “the fatal conceit.”  And I fearlessly predict that this very conceit will be the source of the next crisis.

In more non-Benghazi news, some clearing stories.  (Contain your excitement, people.)

First, Gretchen Morgenson is still wretched. (So I said this was a post about news.  Sue me.)  She kills CO2 absorbing trees to criticize the very thought of providing CCPs access to central bank liquidity:

But placing them at the bailout trough is wrong, according to Sheila Bair, the former head of the Federal Deposit Insurance Corporation. In a recently published book, Ms. Bair wrote that top officials at the Treasury and the Fed, over the objections of the F.D.I.C., pushed to gain access for the clearinghouses to Fed lending.

The clearinghouses “were drooling at the prospect of having access to loans from the Fed,” she wrote. “I thought it was a terrible precedent and still do. It was the first time in the history of the Fed that any entity besides an insured bank could borrow from the discount window.” .

“The Treasury’s and the Fed’s reasoning was that since another part of Dodd-Frank was trying to encourage more activity to move to clearinghouses, we should provide some liquidity support to them,” she said in an interview last week. “Our argument back was, if you have an event beyond their control with systemwide consequences, then you have the ability to lend on a generally available basis. What they wanted was the ability to lend to individual clearinghouses.”

Look, one of the reasons I think Frankendodd is monstrous is precisely because clearing and collateral mandates impose tremendous contingent liquidity demands.  Last week I spoke at in Osaka at the annual meeting CCP12, an organization of 30+ CCPs (which apparently uses the Big Ten as a naming role model).  An exec at an Aussie CCP asked me what the most worrisome unintended consequence of derivatives “reform” would be.  I answered before the words were out of his mouth: the potential for a liquidity crisis in times of market stress.

That’s what happened 25 years ago, on Black Monday and the following Tuesday morning.  The Fed prevented an apocalypse by leaning on banks to lend to FCMs to meet margin calls.

Clearing mandates without some mechanism to provide additional liquidity, either directly to CCPs or indirectly via clearing members, are a recipe for disaster.  Like Gary Gorton, I am increasingly skeptical of moral hazard being the major concern: the major concern is the inevitability of periodic liquidity crises even in efficiently structured financial markets.  Forcing use of clearing and collateralization of uncleared swaps while simultaneously depriving CCPs or their members of access to central bank liquidity would be like mandating the use of matches in an oil refinery and banning fire extinguishers.

So, not surprisingly, Wretched Gretchen goes the wrong way, yet again.

And speaking of wrong way, ICE has received approval to clear European sovereign CDS.  I’ve written before that clearing sov CDS is very problematic, due to the wrong way risk inherent in these trades.  The sovereign-bank feedback loop means that clearing members-or a CCP’s default fund-are required to make big payouts on sovereign CDS precisely when they are under severe financial strain.

ICE Clear Europe claims that it has taken measures to reduce the wrong way risk.  I am deeply skeptical that these measures are adequate.  (Sorry, Paul-I calls ’em like I sees ’em.)

One thing ICE Clear Europe points to is that margins and default fund contributions will be in dollars, not Euros.  This actually creates a new risk. One thing we’ve seen is that during flare ups of the Eurozone crisis is that European banks have faced serious problems accessing dollar liquidity.  Meaning that in the event of a jump to default by a major European sovereign, Eurozone some banks that are members of ICE Clear Europe may well need to come up with big dollars to pay margin calls, or to cover the costs of a defaulting customer, or to meet default fund contributions, but need to do so precisely when they find dollars very hard to come by.

Meaning that (pace Wretched Gretchen) they will be desperately dependent on Fed support through dollar swap lines.

The other measure ICE has taken is to preclude “affiliates” of a sovereign from clearing CDS on that sovereign. Yeah, have to do that, but that doesn’t really come close to addressing the real wrong way risk.  If Spain or Italy-or even Portugal or Ireland or Greece-jump to default, a Eurozone-wide financial crisis that hits all banks will likely result.  Meaning that all major Eurozone banks-including members of ICE Clear Europe-and not just affiliates of the defaulting sovereign, are likely to be in distress at that time.  Further meaning that they will be in distress precisely at the time they are expected to absorb some costs arising from the default (big margin calls, covering the losses of defaulting customers, or incurring default fund obligations).   That’s the wrong way risk we really need to worry about, and nothing that ICE Clear Europe says in its filing with the SEC provides any inkling that their plan addresses that risk.

I also have serious concerns about the risk modeling here.  Wrong way risk is devilishly complicated, especially in a sovereign risk context especially in Europe (given all the potential cross-country linkages).  I am skeptical in the extreme about the ability to set margins properly, and strongly suspect that any methodology is likely to be highly procyclical.

In brief, I continue to believe that clearing sovereign CDS is highly dangerous.  It’s good that ICE Clear Europe recognizes the inherent wrong way risk problem, but in my (strong) opinion, they haven’t really addressed that problem, and indeed may have introduced another source of wrong way risk via the cross-currency mechanism inherent in their design.

I hope I’m wrong.  I hope for all of us it never comes to a test.

Finally, Deutsche Boerse is going to have to stump up $150 mm or so in new capital for Eurex’s clearinghouse, in order to meet European capital standards.  And that’s cheap! LCH.Clearnet will have to come up with 375 mm Euros (or about $500 mm) in new capital:

However, tough new European regulatory capital rules appear to have caught the industry unaware. Eurex is the second major clearing house to admit to a shortfall after LCH.Clearnet, the Anglo-French group, said it would need to increase regulatory capital by an estimated extra €300m-€375m last month

So much for clearing mandates being a cheap way of mitigating credit risk.

We are just approaching the G-20 deadlines to move most derivatives trading into clearing.  And the fun just can’t wait for the official kickoff.  There will be much more fun-and cost, and risk-to come.

Mere days after the collapse of MF Global, I was told by someone who would have reason to know that the key to unraveling the MF mystery was Edith O’Brien, the firm’s assistant treasurer.  A year later, Ms. O’Brien is still in limbo, refusing to testify without immunity from prosecution.

The likelihood that Ms. O’Brien would have conceived of and executed a massive fraud-the looting of MF Global customer segregated funds-is close to zero.  If there was a crime, it would have been conceived of and directed by someone far higher in the firm than Ms. O’Brien.

Prosecutors routinely give immunity to low-level employees in order to build a case against higher executives.  Prosecutors in the MF Global matter seem to be deviating from that routine.  This raises questions, the most notable of which is: are they departing from SOP because the individual who could be implicated is a well-known and highly connected Democratic politician, a former governor and senator, and bundler for Obama?

Maybe there’s a different explanation, but I’m hard pressed to think of one.

How dumb does Jon Corzine think we are?

The WSJ has this hanky puller on his struggles to move on from the wreckage of MF Global:

And the 65-year-old Mr. Corzine is struggling to figure out what comes next for himself, according to friends and former coworkers.

I can hardly type through the sobs.

Stand at LaSalle and Jackson or 10-30 S. Wacker and see how much sympathy you get, Jon.  I’d bring bodyguards.

But here’s where Corzine insults our collective intelligence:

Allegations from shareholders and bondholders that he hid problems or committed fraud at the brokerage firm make “no sense” because he had “no motive,” Mr. Corzine’s lawyers said in a court filing, citing his ownership of 441,960 shares in MF Global. The stake includes 50,000 shares bought shortly before the bankruptcy filing.

Uhm, equityholders in firms teetering on insolvency, or which are insolvent, have a huge incentive to hide problems or commit fraud or take huge risks.  It’s called gambling for resurrection.  Fraud or concealment permit the firm to survive-and maybe it will get lucky.  If things get worse-that hurts only the bondholders, who lose more when the firm loses even more value.  The stock was already worthless.  Ditto with taking on risk: if the insolvent firm’s bet turns bad, that just deepens the bondholders’ losses without hurting the equity holder, but if the bet turns out well the equity profits disproportionately.

Most frauds and concealment of losses are carried out by shareholders.  These are ways of stealing from bondholders.

The only thing that makes no sense is Corzine saying he had no motive.  And he expects us to believe that.

Corzine’s other defense is that MF Global’s failure was due in large part to its completely deficient accounting and control systems.  But that throws him into the Sarbanes-Oxley fire, for he signed off on the soundness of those systems.

Corzine is obviously ginning up the PR machine to try to build sympathy and lay the groundwork for a comeback.   Don’t do the world any favors, Jon.  You’ve done quite enough already.

On Friday’s anniversary of the ’87 Crash, the WSJ put some of the articles from the days after on its website.  This one in particular makes fascinating reading, and is quite enlightening for those who pine for the good old days, when markets were slow and the livin’  (and tradin’) was easy.

For even back in those lost and lamented days when trading took place face-to-face on the floors, during times of market stress things seemed to move fast.  Very, very fast:

And the stock-index markets were leading the way down — fast. In a nightmarish fulfillment of some traders’ and academicians’ worst fears, the five-year-old index futures for the first time plunged into a panicky, unlimited free fall, fostering a sense of crisis throughout U.S. capital markets.

. . . .

Within seconds of the open, S&P 500-stock index futures prices sank 18 points — surpassing the nerve-racking record declines scored in an entire day on Friday. Salomon Brothers Inc. began unloading contracts at an unheard-of rate of 1,000 at a time, dumping more than $600 million in stock-index futures in the first hour of trading alone, one pit trader estimated. Salomon officials couldn’t be reached for comment on the estimate.

[Emphasis added.]

Note too that the big orders are not a modern phenomenon that arose only when HFT algos came on the scene.

And liquidity suppliers fleeing the market is not the monopoly of modern computerized trading where HFT is prevalent:

Then, as buyers fled the market in alarm, trading nearly dried up, temporarily preventing the markets from functioning as a hedging mechanism — their principal reason for existence.

. . . .

Yesterday, as institutions and investors scrambled to lay off at least some of their risk in futures, trading in the index markets virtually dried up at several points, threatening a liquidity crisis on the Merc’s trading floor. At mid-morning, the S&P prices were moving up two points, then back down, in less than a minute, as sellers scrambled to fill orders at any price they could get.

One difference between human and computerized market makers.  Computers don’t cry:

Up the street at the Chicago Board Options Exchange, a market maker wept softly in the men’s room.

One other thing from the article caught my eye:

With trading delayed in many major New York Stock Exchange issues because of order imbalances, Chicago’s controversial “shadow markets” — the highly leveraged, liquid futures on the Standard & Poor’s 500 stock index — were, for just a few minutes, the leading indicator for the Western world’s equity markets.

Shadow markets. Really?  The only market that was open for a while, the only one that was discovering prices-that’s the shadow market?  An interesting comment on the WSJ’s-and Wall Street’s-attitude towards futures markets at the time. Note that now, futures markets are considered worth emulation, and the demonization has been focused on the new “shadow market”: OTC derivatives trading.

As I’ve written numerous times: things aren’t all that different now.  The economics of markets and market making are pretty much the same in computerized and open outcry environments.  When it hits the fan, things move very rapidly in both.  There is no Golden Age of leisurely markets.

Today is the 25th anniversary of Black Monday, the 1987 Crash.  This event had a profound effect on my professional trajectory.  I worked at an FCM at the CME-GNP Commodities-during the Crash.  The firm was owned and run by Brian Monieson, a former chairman of the Merc, and a board member at the time.  I walked into his office on the morning of the 20th, and he told me about how the CME clearinghouse had almost failed.  I had only a dim appreciation for clearing prior to that, but that sparked my interest in the subject.

Little known fact: I Granger Caused the Crash.  Throughout the late summer and fall of  ’87 I had been having issues with my direct boss, and soon after I defended my thesis in August I had received a good offer from one of my advisors, Dennis Carlton, to work at Lexecon.  I tried to work things out at GNP, but by mid-October it appeared hopeless.  I told Brian, and we had several phone calls on the 17th and 18th where he tried to convince me to stay.  I thought it over, and on the evening of the 18th decided that it wasn’t going to work.  So I walked into my boss’s office at 7AM on the 19th and slapped down my resignation letter on his desk.  Apparently the news leaked, and the rest is history 😛

The anniversary has spurred retrospectives from many quarters.  Many of these focus on the role of computers in the Crash, and how this was a harbinger of the supposed horrors the machines are inflicting on the markets today.  One good-well, representative-example of this is “Rage Against the Machine” in the FT:

It has been 25 years since Black Monday, when stock markets crashed around the globe and Wall Street woke up to the risks of computerised trading.

Yeah.  The computers were blamed then.  Suspect number one was “program trading”, a good deal of which was garden variety index arbitrage.  This is not a destabilizing strategy, and numerous postmortems absolved program trading as a cause or aggravator of the Crash.

Indeed, if technology was a problem, it wasn’t that computers were trading too fast: it was that printers were printing to slow.  Seriously.

At GNP we did a little index arb trading.  In the morning, it appeared that the arb was extremely profitable.  The price of the cash index (we were doing MMI) was way, way above where the futures were trading.  It looked like a great opportunity.  My colleague Matt who was in charge of this called down to the CBT floor before doing a trade, to see where the floor was trading.  Our floor clerk said (I don’t remember the numbers exactly): “Somebody is offering X over here.  Somebody else is offering X+20 over there.  Somebody else is offering X-20 over there.  I have no fucking idea what the price is.”  Matt didn’t make the trade.

Which was good, because the apparent opportunity was a mirage.  That’s where the slow printers come into play. Specialist posts on the NYSE had old fashioned daisy wheel printers.  Very, very slow.  They were overwhelmed by the order flow.  At 10AM the printers were spitting out orders that had been entered at 8 or earlier.  So the orders being executed on the NYSE were actually very stale, and the prices didn’t reflect current market conditions.  The futures didn’t have that problem.  So at 10 or 11 NYSE prices were reflecting orders submitted hours before, and the futures were reflecting current conditions.  Hence the futures were way below the cash, making it appear that there was a huge arbitrage opportunity.

The problem was that this induced more people to submit sell orders to the NYSE before they caught onto the fact that NYSE prices were not reflective of current conditions.  This exacerbated the backlog on the printers.

So it wasn’t fast technology that caused problems on 19 October ’87.  It was slow technology.

Program trading wasn’t an issue, really, but portfolio insurance was.  This is sometimes called “computerized trading” but it’s not, really.  Yeah, computers were used to calculate deltas, and these deltas were used to determine trading strategies.  You could have used an HP-12C (complete with Reverse Polish Notation!-and no, that’s not an ethnic joke) and the normal cdf table from Handbook of Tables For Mathematics (pp. 922-929 of the Fourth Edition) to do the same thing.

The problem with portfolio insurance was that, unlike index arbitrage and most market making strategies employed today in HFT, it was a positive feedback strategy, rather than a negative feedback strategy.  As prices fell, portfolio insurers had to sell more, which drove down prices further, which led them to sell more . . . until they pulled the plug on the strategies.  That is, unlike market making strategies which are buy low-sell high trades, portfolio insurance was buy low, sell lower.

The FT article uses the ’87 Crash as a springboard to make the usual litany of complaints about current market structure and computerized trading.

Some of the criticisms are defensible.  The current fragmentation of equity structure in the US is indeed the product of SEC RegNMS, which I characterized at the time of its introduction as implementing an “information and linkages” approach to market structure, in lieu of mandating a CLOB.  This socialization of order flow has some problems, particularly during times of market stress.  Links are vulnerable during times of stress.  Moreover, the proliferation of order types that has complicated trading dramatically is directly the result of this approach: many of the new order types are related to order routing, which is a much more complex task with many execution venues as opposed to one (as in futures markets where order flows are not socialized).

Other criticisms are less defensible.  The authors of the FT piece are apparently scared of the dark, as they warn of the dangers of dark pools.  These things are not new.   They just used to be called “third markets” or “block markets”.

The FT piece also warns that in the computerized world, liquidity can evaporate quickly.  They acknowledge that liquidity evaporated quickly in the old days-as it did on Black Monday-but suggest that can happen more quickly today.  Not really.  At all.  Locals could shut up or keep their hands in their pockets very quickly back on the floor if it looked like order flow was getting toxic.  And they were pretty quick at picking up on that.  Moreover, during the Crash clearing firms pulled their locals from the pits.  You would have thought that the pits would have been in a state of pandemonium on the 19th, but after the initial frenzy, they were actually spookily empty, as most locals and many brokers had been yanked from the floor by their clearing firms.

In brief, the functions of markets haven’t changed.  The technology for performing these functions has.  But the fundamental economics of performing the functions hasn’t.  Face-to-face and machine-to-machine markets have the exact same basic vulnerabilities.  Those who focus on the technology miss the economics.

The FT article, and others like this one in Bloomberg,  blame computerization and HFT, and the consequent alleged “loss of confidence” among investors, for the decline in equity volumes recently.  Color me skeptical.  Futures volumes have dropped too, despite a very different market structure, and a different composition in market users.

Historically, trading volume has ebbed and flowed.  It ebbed and flowed in the pre-computer era. It shouldn’t be any surprise that it ebbs and flows now.

If you are looking for the big lesson from the  1987 Crash that we should heed today, ignore all the BS about technology.  Look at clearing.  Look at the Brady Report and other post-Crash studies of what happened in clearing.  That’s what almost brought the markets down.  The operation of variation margining-which is usually a source of stability-threatened to bring the markets to a halt, with even more devastating consequences.

Then think of what will happen during the next big market move, given that the scope of clearing has been expanded substantially due to Frankendodd, and parallel efforts around the world.  Don’t worry about the technology of execution: worry about what happens after the trade, during clearing and settlement.  That’s where the truly systemic vulnerability lies.

There’s an old adage in the military: amateurs talk tactics, professionals talk logistics.  In the markets, the parallel is that most commentary focuses on execution, when much of the real important action happens out of sight, in clearing and settlement-the logistics of the financial markets.  That happened in post-Crash commentary, and it is being repeated today.  That’s a big mistake.  When looking for object lessons from Black Monday, don’t look at the computers and the execution of trades.  Look at what almost happened with disastrous consequences in clearing.  And worry deeply about how the system is vulnerable to a repeat in the future.  Arguably more vulnerable, given the dramatic growth in the size of the markets and the mandated reliance on clearing, and margining of non-cleared derivatives.

That’s the lesson I first began to grasp in Brian’s office early on 20 October.  And that experience has decisively shaped my criticism of efforts, like Frankendodd, intended to fix the markets.

As soon as I heard about Google tanking 10 percent, leading to a trading halt, in response to a prematurely released earnings announcement, I asked myself: “I wonder how long before someone blames HFT.”  I didn’t have to wait long.  Almost immediately afterwards, Jim Cramer (gag) and Harvey Pitt were on CNBC putting the blame on computerized trading.

Let me get this straight.  Extremely bearish information about GOOG is released.  GOOG immediately tanks.  Trading in the stock is paused.  On resumption of trade, the stock trades a little off its lows, but 8 percent below the pre-information level.

Uhm, isn’t that the way efficient markets are supposed to work?  Aren’t prices supposed to drop immediately upon the release of bad news, and stay down (absent any offsetting good news)?   Didn’t this happen before HFT?  Like forever?

So what’s your problem, Cramer?  (I’m talking about the market, not you personally-I don’t have enough time to even begin with your issues.)  Are you just ticked that the price doesn’t move down slowly, giving turkeys like you a chance to make money at the expense of even slower turkeys?

I often quote Captain Renault (Claude Rains) from Casablanca to describe how any price move in commodities is pinned on “speculators”: “Round up the usual suspects.”  When it comes to any big move in the stock market, the only thing that has to be changed is to substitute the singular for the plural: “Round up the usual suspect.”  Because its always about HFT/algos.  High frequency scapegoating.

Google was PO’d at the premature release of the earnings numbers by RR Donnelly.  The main reason it was PO’d is that the premature release prevented it from spinning the awful news.  When it did have the opportunity, Larry Page delivered one of the most mendacious statements imaginable:

“We had a strong quarter,” Page’s statement said. “Revenue was up 45 percent year-on-year, and, at just fourteen years old, we cleared our first $14 billion revenue quarter. I am also really excited about the progress we’re making creating a beautifully simple, intuitive Google experience across all devices.”

“I’m really happy with our business…Not bad for a teenager,” Page added on the earnings call.

Who you gonna believe, Larry or the lyin’ market?

Do no evil.  More Orwellian by the day.

This afternoon I attended the Working Group on Financial Markets at the Chicago Fed.  The scintillating topic was segregation models.  Really!  It was scintillating!  For a certain kind of geek, of which I am one.

It was scary, actually.

Segregation of customer money has been a subject of discussion post-Frankendodd, and I have written several posts on the subject.  Segregation has received even more discussion post-MF Global (AKA Corzine-gate, but since he’s a made man I guess he will skate).  The model that has been implemented for cleared swaps, and which (according to clearing maven John McPartland of the Chicago Fed) is likely to be adopted for cleared futures is LSOC-legally segregated, operationally commingled.

Back in the summer of 2011, I wrote that segregation could make the markets more fragile, because it would tend to reduce credit (mainly intraday credit) used to finance variation margin.  This is important, because the markets depend on using credit to fund margin payments.  If this credit freezes up, the markets will freeze up.  Indeed, a cleared system works on such tight deadlines that an interruption of credit can be catastrophic.  If margin calls aren’t met in a timely fashion, absent credit, margin payments don’t flow to those on the winning side of trades.  When this happens, the clearing system breaks down.  And in a Frankendodd world dependent on clearing, a breakdown in clearing means a meltdown in the markets.

Indeed, even delays of hours or even minutes in making margin payouts, or doubts that CCPs will make margin payments in a timely fashion, can be catastrophic.  Almost exactly 25 years ago, on 19 October, 1987, the mere rumor that the CME would not pay out variation margin led to a run on FCMs and the CME clearinghouse that almost brought the market to a crashing halt.

One of the speakers at today’s event, Barclays’ Kevin Murphy, noted that under segregated models FCMs don’t have a lien on  the collateral in customer accounts.  Which means they won’t extend credit to customers because there is no collateral backing the loans.  Murphy said that broker intraday credit is likely to be a thing of the past under greater segregation.

Think of the consequences on a day when markets move a lot.  Those on the winning side are expecting to receive variation margin payments.  Those on the losing side will be scrambling for cash to meet their VM obligations.  Where will they get it?  Not from their FCMs.  From their banks?  Uncertain-even if the customers arrange credit lines, banks can often find reasons to delay providing the credit, or not providing it at all.

This all means that there is a risk that VM owes will not be paid in time.  With no credit being extended, or the amount of credit being sharply constrained, there is a serious risk that VM pays will not be made on time.   If that happens, particularly during a period of market stress, all bets are off.  Almost literally.  People will fear that CCPs are insolvent, and there will be runs on them-people will liquidate positions to recover their margin money.

That would be very ugly indeed.  Again, a cleared system is very tightly coupled, more tightly coupled than OTC markets.  Tightly coupled systems are more prone to going non-linear, and failing catastrophically.  Segregation increases the tightness of the coupling.   Connect the dots.

Of course, markets don’t stand still.  People will recognize the need for contingent liquidity, and make arrangements for it.  But will those arrangements be as robust as the system we have now?  There is serious room for doubt.  If more robust alternatives are available, why weren’t they chosen before?  I know this argument is not dispositive, given the coordination issues involved, but there are strong incentives to adopt better systems.   We should be very leery of changes that implicitly assume that market participants with large amounts of money and risk in the game systematically choose wrong.

The whole move to clearing has been intended to wring credit risk from the derivatives markets.  But every move to reduce credit risk-including moves to greater segregation-almost always involve creating greater liquidity risk.

If given a choice between credit and liquidity risk, I would choose credit risk every time .

In other words, you have to pick your poison: credit risk or liquidity risk.  Yeah, credit risk may be like arsenic.  But liquidity risk is more like cyanide.

I know which one I would choose.